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Bank Welfare: The Rate Hike

Written by Geoffrey Pike
Posted December 18, 2015 at 1:49PM

The Federal Open Market Committee (FOMC) released its latest monetary policy statement on Wednesday. As expected, the Federal Reserve will hike its key interest rate known as the federal funds rate.

This is the first time the Fed has hiked rates since 2006. The federal funds rate has been near zero for seven years. After many months of excuses, the FOMC finally approved a rate hike. You can read the FOMC statement here.

To spare you the time and agony of reading the whole statement, I will quote the key parts.

The key sentence that everyone was waiting for is as follows: “Given the economic outlook, and recognizing the time it takes for policy actions to affect future economic outcomes, the Committee decided to raise the target range for the federal funds rate to ¼ to ½ percent.”

The federal funds rate is a target rate for the Fed. Since 2008, the target has been a range instead of an exact number. For seven years, the range has been between 0% and 0.25%. So this rate hike is in effect a hike of 0.25% (25 basis points) in the range.

The FOMC statement also addresses the Fed’s balance sheet. It states: “The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.”

In other words, the Fed is keeping a neutral monetary policy in terms of the base money supply. It will just continue to roll over maturing debt.

In the past, a hike in federal funds rate would have typically meant a tighter monetary policy. The Fed would hike rates by decelerating the growth in base money, or perhaps even deflating the money supply. It controlled the federal funds rate by how much money it created out of thin air.

Since 2008, the Fed has approximately quintupled the adjusted monetary base from just over $800 billion to $4 trillion. Much of this newly created money went into bank reserves. Therefore, banks do not need to borrow overnight money to meet reserve requirements. The overnight lending rate between banks is exactly what the federal funds rate is.

The massive excess reserves held by banks have kept the federal funds rate near zero due to the low demand for overnight borrowing. The Fed’s monetary policy has not mattered in this respect. So how is the Fed going to hike this rate if banks don’t need to borrow from the overnight window?

Interest on Reserves

The latest FOMC policy statement was a little different this time around in that there was an attachment at the end. It was instructions on how it would achieve its objective of raising the federal funds rate to a range of 0.25% to 0.5%.

The primary means of doing this is stated as follows: “The Board of Governors of the Federal Reserve System voted unanimously to raise the interest paid on required and excess reserve balances to 0.50 percent, effective December 17, 2015.”

This is the only way the Fed could raise the federal funds rate without selling off trillions of dollars of assets on its balance sheet. The Fed will now have to pay the banks half a percent on their reserves. Up until now, the Fed had been paying one-quarter percent.

It gets a bit complicated here, but the interest paid on bank reserves essentially puts a floor under the overnight bank borrowing rate — or at least that is what the Fed hopes it does.

It creates something of an arbitrage opportunity, where the demand to borrow overnight money will increase due to being able to keep the money on reserve with the Fed to “earn” a higher interest rate.

This has not received much attention in the mainstream press. We just hear about rate hikes. We don’t hear about how it is going to be achieved in the form of paying banks not to lend.

Welfare for Bankers

While the stated purpose of the Fed is to seek to foster maximum employment and price stability, the true purpose of the Fed is two things: to help the major banks and to help finance the government’s deficits.

With this latest decision, Janet Yellen and company are certainly helping the big banks. These banks already have trillions of dollars piled up in reserves. They are not lending this money out. Now the Fed is going to hand them an additional 0.25% to keep the money there. It is free money for the banks.

So you may be wondering, where does the Fed get the money to pay the banks?

Each year, the Fed makes a profit from the interest collected on the assets that it holds. This consists of U.S. government debt and, to a lesser extent, mortgage-backed securities.

When you have a digital printing press with which you can create unlimited amounts of money out of thin air, it isn’t too hard to make a profit.

The Fed uses this “profit” to fund its expenses. The rest of it is returned to the U.S. Treasury, which then uses it to fund its general expenses.

If the Fed is paying more to the banks not to lend, then this will mean less “profit.” If the Fed keeps hiking rates, this will really start to add up. It will mean less money remitted back to the Treasury each year. This will mean less money for the federal government to spend. In reality, it will probably just mean a higher deficit.

To sum it up, the banks will be getting paid money to not lend. This money will essentially come from the U.S. Treasury, which means the government, in order to spend the same amount of money, will either have to raise taxes or run bigger deficits. It will be the latter for now.

When you listen to the financial news, they don’t quite put it in these terms.

Impacts on the Economy

There isn’t much you can do about the banks collecting more money. But what are the impacts of this rate hike?

It means that, if anything, bank lending will be reduced on the margin. This has a similar effect as a reduction in the money supply, as the process of fractional reserve lending reverses.

The Fed has already been following a tight monetary policy for just over a year. This latest move indicates that reduced lending could make it tighter. This is after unprecedented monetary inflation from 2008 through 2014.

The problem is that all of the previous monetary inflation has built up dislocations in the economy. Resources have been misallocated. We have already seen that in the energy sector, particularly in regards to oil. These dislocations may become more evident as liquidity dries up. This makes an economic downturn more likely.

Unfortunately, I fear that if there is a recession, people are going to blame the Fed’s rate hike. The Fed is at fault, but not because it raised its key rate a quarter of a percent. It is at fault because of the huge monetary inflation that happened over the course of six years, which enabled massive bailouts and massive government deficits at low rates.

If there is a recession on the horizon, it was already baked into the cake. The tighter monetary policy is just going to expose the misallocated resources more easily, but they would have been exposed at some point anyway. In other words, bubbles will go bust.

If we see a major downturn, the Fed will get criticized, but for all of the wrong reasons. We can expect Yellen and company to panic and to start ramping up the digital printing presses again in the future. Until that time, be prepared with a higher than normal allocation in cash and cash equivalents. In an economic downturn, cash will still be king.

Until next time,

Geoffrey Pike for Wealth Daily

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